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An Informative Piece on Making Better Decisions with Cost Modelling

The ISM recently published an informative piece on how to make better decisions with cost modelling. Given that projected cost modelling can help supply management organizations reduce procurement costs and generate information that could improve cost performance throughout the supply chain, proper cost modelling is something every organization should have a good grip on.

The breakdown graphic is very good. The cost of any particular good is:

the direct material costs plus

the direct labour costs plus

the indirect overhead costs plus

the (amortized) SG&A costs (of the organization) plus

the (amortized) R&D costs plus

the profit margin

The last three costs in particular should not be overlooked. While they will typically be small in comparison to the other costs, they are there, and they cannot be driven to zero no matter what the volume requirements or the economies of scale. They will always exist, and squeezing a supplier’s profit margin to unreasonable levels seriously jeopardizes the health of the supplier. In addition, while tempting to do so, SG&A costs that are not directly applicable to the good being produced should not be included in the indirect cost. While the indirect costs can be reduced with production line efficiency, SG&A cannot.

And cost models are not hard to build, at least approximately. Direct material costs can be estimated using public indexes, direct labour costs can be estimated using government statistics bureau data, overhead costs can be estimated using government statistics bureau data and industry averages, SG&A can be estimated using public filings, R&D cost ca n be estimated as an industry average percentage, and profit margin can be estimated using a fair percentage.

Furthermore, cost models are even easier to correct. Simply state that, unless the supplier proves the model wrong, you will assume that it is right and base your negotiations off of it.

And once you have a correct cost model, you not only gain deep insight into a supplier’s costs, but into their inefficiencies. For example, you will learn where they are spending too much on raw materials, whether or not they are not competitive in labour costs, and where their processes are inefficient. Then, you can work with them to either help them negotiate better contracts with their raw material suppliers or buy on their behalf (with a larger aggregated demand that you can use to leverage a better contract) and to remove inefficiencies from their processes. This can create win-win situations and give you preferred customer status, which will be beneficial if demand outstrips supply.